EDS Back on Track

After several years of struggle, Electronic Data Systems ( EDS) appears to have turned a corner.

Shares in the Plano, Texas-based IT services giant recently broke through peaks set a year ago, as investors are gaining confidence that the company has started to focus on clearing the way to further growth.

"The company has gotten through a number of problems, and they've gotten their house in order," says Standard & Poor's equity analyst Dylan Cathers. "They've finished restructuring, steadily increased their offshore capabilities, and their balance sheet is in shape."

EDS set a recent 52-week high last month following a meeting with analysts that sparked an upgrade by RBC Capital's Cynthia Houlton.

"Our rating change and higher price target reflect a shift by the company to growth for the first time since 2002," Houlton wrote. She raised her price target to $33 from $26. Her firm has provided EDS with nonsecurities services in the past 12 months.

On Tuesday, EDS closed up 1.5% to $27.78 after pulling back nearly 7% from its 52-week high of $29.94.

In its latest quarter , EDS beat the Street's forecast on the top and bottom lines and nearly doubled its profit over the comparable period in 2005. Signings hit $7.6 billion for the quarter vs. $5.3 billion in the same period last year.

Houlton noted that "the success of the turnaround was emphasized through improvements from 2003 to 2006 in multiple metrics, including adjusted EPS (loss of 39 cents to positive 99 cents), free cash flow ($221 million to $887 million), net debt ($3.9 billion to $200 million) and book-to-bill (0.64x to 1.25x)."

New contract signings also have made progress. EDS reported $26.5 billion in total contract signings in 2006 compared with approximately $20.1 billion in 2005 and $14 billion in 2004.

Gross margins have improved the past two years, coming in at 12.6% in 2006.

Dane Anderson, a research director at Gartner, credits the EDS leadership with helping to move the company on the right path. Jordan, President and COO Ron Rittenmeyer and the company's head of applications services, Charlie Feld, have helped return EDS' focus to its customers.

The company had been "doing a bit more navel-gazing instead of looking out at the marketplace and figuring out what clients wanted," Anderson says.

Indeed, customer satisfaction was a key part of Rittenmeyer's presentation at the recent EDS analysts' meeting.

"Issues around outages, issues around failures are things that we are going to make personal," he said. The difference between EDS and the competition, he said, is that "we will do what we say and we will do it more consistently."

"It's important we get our clients the most impeccable service they could ever want," Rittenmeyer said.

However, getting back to the levels of its glory days earlier in the decade will be far from easy. During the years that EDS struggled, rival IBM ( IBM) "not only leapfrogged them but left them in the dust," says Bob Djurdjevic, president of Annex Research and longtime EDS shareholder. "The scenario is different in which they have to compete."

Several problem contracts hurt EDS' earnings and cash flow between late 2002 and 2005, including a botched deal with the U.S. Navy and Marine Corps.

"That was a classic example of a mega deal that goes bad and causes mega problems," Djurdjevic says.

"They've had some pretty humiliating years behind them, and hopefully they're going to take a lesson of humility and apply them to their future plans," Djurdjevic says.

Historically, EDS has been best known for its infrastructure services work. But to boost growth, the company now wants to "move up the stack" to higher-margin segments such as applications development and business process outsourcing.

The company has already snagged some new applications business from existing clients, says Anderson, and its majority stake in India-based Mphasis rounds out its applications capabilities. The Mphasis pickup recently helped the firm land a deal with Vodafone ( VOD).

Also key to the strategy is developing applications and products to serve specific industries, such as healthcare, financial services and government sectors. Analysts expect the company to be aggressive about acquisitions to ramp up its capabilities.

In addition, with its financial flexibility and margin improvements, EDS is in a good position to acquire, Cathers says.

RBC's Houlton noted that EDS has an "annual M&A budget of $1.5 billion to $2 billion to drive $3 billion to $4 billion in incremental revenue by 2009."

CEO Mike Jordan hinted during its latest earnings call that the company could make a major purchase worth more than $1 billion.

Even with the run-up in the stock since he rated the stock a buy last May, S & P's Cathers says, "we think the stock still has some room. 2007 could be a good year for the company." He calls its price-to-earnings ratio of 20 "very reasonable." He does not own EDS shares and his firm does not do banking.

Investors looking to park some money in a blue-chip name may want to take notice of a stock that seems to have found new life.